How Are Currency Exchange Rates Determined?

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The question of how exchange rates for particular currencies are determined in relation to other currencies is quite popular among travelers. In other people, it is a phenomenon that evokes great curiosity, and rightfully so. This is because there is sometimes a huge disparity on the returns that different currencies accumulate in respect to others. For instance, travelers visiting a foreign developed country are likely to receive maybe 1-1.5 times or 0.65-0.8 times the unit value of the currency in that respective country. However, if the travelers are visiting a third world country, they can sometimes receive up to 100 times the unit value of their country’s currency! This is a huge disparity that should make anybody ask questions.

On the surface, it might look like a tough complicated exercise trying to understand why there is such a huge difference in these figures. However, the reasons are simpler than you might think. Here are a few to keep in mind.

1. Demand and supply.

Just like any other product in the world, the difference in the prices is determined by the market forces of supply and demand. The more in-demand a product is the more valuable it becomes. The less sought after a product is the less valuable it is deemed and hence the lower the price tag that is attached. With this in mind, currencies of first world currencies tend to have much higher values than those of third world currencies because these currencies are in much higher demand. Some of the factors that influence the demand of a currency include a country’s fiscal policies, a country’s imports and exports e.t.c which are examined briefly below.

For users traveling to Canada, Ottawa exchange rate information can be accessed through money changing websites such as Knightsbridge FX or other financial institutions.

2. Speculation

Speculation involves the ability to determine whether a given currency’s value is likely to rise or fall in the future depending on the changing circumstances e.g. a change in the political climate, a change in the labour force e.t.c. There are currency instruments available that can speculate rates for specific countries. Depending on the outcome, there is usually a massive buying or selling of a given currency and this contributes to the overall supply and demand of the currency causing an elevation or depreciation of the currency value.

3. Fiscal Policies

Fiscal policies refer to the strategies adopted by the government in determining its revenue spending plans as well as determining its tax rates. These policies do not only determine a country’s economy but they also affect the perceived value of the nation’s currency. If a country’s fiscal policies are viewed as favorable by the global community and in particular, global investors, it is likely that more investors will choose to fund projects in that country thus causing a surge in the value of the country’s currency. The opposite applies as well.

4. Imports and Exports

Have you ever wondered why governments in all countries are always coming up with ways to incentivize exports and reduce the amount of goods and services they import? In most developed countries exporters receive special privileges such as tax breaks and low interest loans while importers are burdened with high tax levies and stringent policies. This is because exports strengthen the value of a given currency by requiring the buyers to pay in the exporter’s currency. This in turn raises the currency’s demand. On the other hand, importing goods requires a given country to pay for the goods using the seller’s currency. This raises the demand of the seller’s currency thus strengthening its value.

5. Interest rates on government bonds

It may not seem like it but the interest rate a government attaches to its bonds contributes significantly to the strength of a given currency. If the rates are high to the point where they are sufficient to cover foreign market risk, then they will attract foreign capital to the country. This is because investors feel comfortable to invest in the country. If, on the other hand, investors are not comfortable with the interest rates it would repel a significant number of them and the result would be less money entering the country through investment projects thus lowering the value of the country’s currency. Similarly, the level of government debt has been shown to attract or repel investors and as a result cause fluctuations in the value of a country’s currency.

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